Downsizing the big banks: A long-term solution

The hundreds of billions in rescue funds needed to support banks -- and the trillions in implicit subsidies -- has brought the question of appropriate institutional size to the forefront of regulatory reform. Not surprisingly, FDIC Chairwoman Sheila Bair and Federal Reserve Chairman Ben Bernanke favor measures collectively intended to limit the size of banks in the future, Bloomberg Newsreports.

Options include raising capital ratios as a bank increases in size, accelerating the increases in fees paid to the FDIC, and lowering the cap on the percentage of nationwide deposits any one bank can take. Overall, the goal is to have "financial disincentives for size and complexity," according to Bair. Complexity encompasses untraditional banking activities, such as the proprietary trading that drove Goldman Sachs' (GS) hugely profitable quarter, as well as investing in structured financial products.

There's no doubt that the majority of large banks took on more risk than they could handle during the last few years. Scale can be helpful in banking, but it can also mean that improper activities are occurring because management's oversight is less effective. A trillion dollar-plus balance sheet can hide a lot of bad assets and hidden risks. As the too-big-to-fail debate rages on, the real goal is how to avoid a bank that is too-big-to-rescue.

If it seems absurd that the current raft of bailout programs could need to be repeated one day in such a larger size as to be impossible for the U.S. government to finance, consider what's happening in the financial system now. As certain banks go under (like Washington Mutual) and others are absorbed (like Wachovia) -- the result is greater concentration of banking assets under the survivors. I've argued elsewhere that this is both a natural and healthy part of market cycles. However, if the government is implicitly supporting existing large banks -- keeping them around in the hopes that they can help clean up the mess by taking over other failed institutions -- then all bets are off.

The current working plan of regulators and the Treasury Department is to increase concentration in the banking system, but it's a near-term patch job and the exact opposite of what's necessary long-term. Promoting stability means promoting an environment where the failure of one does not lead to a potential failure of all, and that's tough to do when the top handful of financial institutions have huge balance sheets and extensive counterparty entanglements with each other. If that means creating a well-defined line between the dealings of regulated banks and unregulated investment banks or hedge funds, then that discussion should be on the table.

Luckily, America hasn't yet been confronted with a financial crisis "fix" that exceeds its capacity to borrow. But to ensure that doesn't happen in the future, institutions need to be appropriately sized so that they aren't crucial enough to create the hope for financial help when times get tough.

James Cullen edits and writes at CollegeAnalysts.com. He is the vice president of the Boston College Investment Club, which owns shares of GS, but he has no personal position in the stocks mentioned above.